Friday, March 20, 2009

Here is another example from the list of “things that we saw coming, but nobody cared.” Credit card companies are suffering from record default rates. In the fourth quarter of 2008, credit card companies charged off – declared as uncollectible – a whopping 6.3 percent of their debt. Aside from a fluke spike in the data in the first quarter of 2002, this was the largest charge-off rate since the Federal Reserve began collecting these data in 1980.

Interestingly, these record setting losses for credit card lenders come after the punitive changes to the bankruptcy code were supposed to weed out the “deadbeat” borrowers and lead to lower default rates. Apparently, things did not work out as planned.

The credit card quality continued to deteriorate for a number of reasons. First, credit card lenders happily filled the void left by less access to mortgages starting in early 2006, as my colleague Tim Westrich and I documented in a report for the Center for American Progress last year. Credit card lenders expanded their business when everybody who had paid any attention knew that the overall credit quality was already deteriorating.

Second, people borrowed money because they had to. The argument that all forms of household debt, including credit cards, were caused by irresponsible borrowers has never jibed with the data. For instance, data from the Federal Reserve’s Survey of Consumer Finances show that families became less accepting of debt for conspicuous consumption over time. Also, irresponsibility cannot explain why the growth rate in debt abruptly changed after 2001. Interest rates after all fell much more slowly in the 2000s than in the 1990s. And finally, people would have to plaster the walls of their homes with plasma screen TVs, have a different iPod for every day of the year, and rent out storage units for all of their new designer wardrobes to explain the enormous additional debt that families have taken on.

Third, credit card companies milked every last dollar out of their preferred customers, the so-called “revolvers” – people who carry a balance and make some payments. Higher interest rates, increased fees, and fewer perks were typically in store for these card holders when defaults surged. The only problem with this strategy is that it will lead to an acceleration of credit card default, especially in a recession. Still, a number of credit card companies are raising their fees, cutting back on perks associated with their cards, and raising interest rates right now, even though consulting firms already estimate that the average chare off rate could go as high as 8 percent to 9 percent this year. Apparently, bilking the customer in the current quarter beats making sure that the customer can still pay the bills next quarter.

Some lenders, though, are trying to clean their balance sheet by getting rid of a selection of risky borrowers, such as American Express with its announcement to pay certain borrowers $300 if they pay off their balance and close their accounts before a specific date. They are probably not doing this out of the goodness of their hearts. Rather, having a lot of bad debt out there could cost them a hefty chunk of change. American Express already disclosed a net charge off rate of 8.7 percent in February 2009. A substantial amount of credit card debt, though, is securitized. When the excess returns on the securitized funds – earnings for investors – shrink far enough because of a rise in defaults, the investors can ask for more cash from the credit card lender or, in extreme cases, demand their money back. The term liquidity crunch probably does not aptly describe what this would mean for credit card companies.

The worst part of this crisis is that it was foreseeable. For decades, credit card companies have layered fees and excessive interest rates on their borrowers. Instead of addressing the consequences of high, complex, poorly understood credit card costs, though, the high default rates were simply explained away by declaring defaulting borrowers as deadbeats. Now that there won’t be another round of bankruptcy reform that could be sold as salvation, credit card lenders will have to come to terms with the fact that their practices were actually detrimental to their own financial health.